In the first seven months of 2013, the stock market gained 2.44% in January, 0.10% in February, 3.36% in March, 2.27% in April, 3.04% in May, -0.97% in June and 5.69% in July. The market reached its historical high on Aug. 2, 2013. So far this year the market has made multiple fresh new highs. This is after a double-digit return gain in 2012. The stock market likes the good economic news and the earnings reports. PMIs are better than economists’ expectations. The Institute for Supply Management (ISM) said its index rose to 55.4 as of July 1, 2013. The unemployment rate ticked lower. There is a saying that if the market is up in January, it will be up for the year. We don’t know if this is true, but it looks that way at least so far this year. As investors are happier with the higher balances in their account, they should never forget the word “RISK,” which is directly linked to the valuations of the asset they own. A higher current valuation always implies a lower future return.

As pointed out by Warren Buffett, the percentage of total market cap (TMC) relative to the U.S. GNP is “probably the best single measure of where valuations stand at any given moment.”

Knowing the overall market valuation and the expected market returns will give investors a clearer head on where we stand for future market returns. When the overall market is expensive and positioned for poor returns, the overall market risk is high. It is important for investors to be aware of this and take consideration of this in their asset allocation and investing strategies.

Please keep in mind that the long-term valuations published here do not predict short-term market movement. But they have done a good job predicting the long-term market returns and risks.

Wise man Howard Marks also pointed out that investors should always know where we are with the market. Predicting the direction of the market is hard. But investors can always make educated decisions based on current conditions.

Howard Marks thinks that “most assets are neither dangerously elevated (with the possible exception of long-term Treasury bonds and high grades) nor compellingly cheap. It’s easier to know what to do at the extremes than it is in the middle ground, where I believe we are today.” He wrote in his latest memo.

Why did we develop these pages?

We developed these pages because of the lessons we learned over the years of value investing. From the market crashes in 2001 to 2002 and 2008 to 2009, we learned that value investors should also keep an eye on overall market valuation. Many times value investors tend to find cheaper stocks in any market. But a lot of times the stocks they found are just cheaper, instead of cheap. Keeping an eye on the overall market valuation will help us to focus on absolute value instead of relative value.

The indicators we develop focus on the long term. They will provide a more objective view on the market.

Ratio of Total Market Cap over GDP - Market Valuation and Implied Returns

The information about the market valuation and the implied return based on the ratio of the total market cap over GDP is updated daily. The total market cap as measured by Wilshire 5000 index is now 112.6% of the US GDP. The stock market is likely to return about 2.1% a year in the coming years. As a comparison, at the beginning of 2013, the ratio of total market cap over GDP was 97.5%. It was likely to return 4% a year from that level of valuation. The 15.1% gain since the beginning of 2013 has reduced the future gains by about 1.9% a year.

For details, please go to the daily updated page. In general, the returns on investing in an individual stock or in the entire stock market are determined by these three factors:

1. Business growth

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over the long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividends are an important portion of the investment return. Dividends come from the cash earning of a business. Everything equal, a higher dividend payout ratio, in principle, should result in a lower growth rate. Therefore, if a company pays out dividends while still growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, its stock price often does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual businesses, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

Putting all the three factors together, the return of an investment can be estimated by the following formula:

This model has done a decent job in predicting the future market returns. You can see the predicted return and the actual return in the chart below.

The prediction from this approach is never an exact number. The return can be as high as 10% a year or as low as -2% a year, depending where the future market valuation will be. In general, investors need to be cautious when the expected return is low.

Shiller P/E - Market Valuation and Implied Returns

The GuruFocus Shiller P/E page indicates that the Shiller P/E is 24. This is is 45.5% higher than the historical mean of 16.5. Implied future annual return is 1.7%. As a comparison, the regular trailing 12 month P/E is 19, higher than the historical mean of 15.8. That is also why the media pundits are saying that the market is cheap.

Twelve months ago, the Shiller P/E was 22.3, and the regular trailing 12-month P/E was around 16. The market did look cheap with trailing 12-month P/E.

The Shiller P/E chart is shown below:

Over the last decade, the Shiller P/E indicated that the best time to buy stocks was March 2009. However, the regular P/E was at its highest level ever. The Shiller P/E, similar to the ratio of the total market cap over GDP, has proven to be a better indication of market valuations.

Overall, the current market valuation is more expensive than the most part of the last 130 years. It is cheaper than most of the time over the last 15 years.

John Hussman uses the peak P/E ratio to smooth out the distortion of the corporate profits caused by the fluctuations of the profit margins. The current market return projected by his model is around 2.9% a year.

In his commentary on July 15, 2013, Rock-A-Baby, his estimate of prospective 10-year S&P 500 nominal total returns dropped to 2.9% annually. Given that the dividend yield on the S&P 500 is just over 2%, this works out to a projection that the S&P 500 Index will be at nearly the same level a decade from today as it is at present.

As mentioned in his article, since 2003, actual 10-year returns have exceeded, by a few percent annually, the 10-year returns that they projected at the time (they still shifted to a very constructive view in 2003 based on early improvements in market action, having none of the Depression stress-testing concerns that prevented a similar response in 2009). The stronger-than-estimated returns for the S&P 500 reflect the extreme valuations at present. Again, they currently expect total nominal returns on the S&P 500 to average less than 3% annually over the coming decade, with most of that from dividends, implying an S&P 500 Index still near its present level in 2023 (though undoubtedly after an exciting roller coaster to nowhere along the way).

This agrees with the returns projected by the ratio of total market cap over GDP and Shiller P/E.

In all the three approaches discussed above, the fluctuations of profit margin are eliminated by using GDP, the average of trailing 10-year inflation-adjusted earnings, and peak-P/E, revenue or book value ,etc. Therefore, they arrive at similar conclusions: The market is overvalued, and it is likely to return only 1.7% to 4% a year in future years.

Jeremy Grantham’s firm GMO publishes a monthly seven-year market forecast. According to Ben Inker and James Montier’s quarterly letter What the *&%! Just Happened? and The Purgatory of Low Returns, today’s opportunity set is characterized by almost everything being expensive. Montier believes this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world. Montier advises that investors should “be patient” at this point.

As of June 30, 2013, GMO’s seven-year forecast is below:

GMO expects the U.S. large cap real return is -1.2%. This number does not agree with what we find out with the market/GDP ratio and Shiller P/E ratio. The U.S. high quality’s return is expected to be 3.7% a year.

Insider Trends

As indicated by the three different approaches discussed above, the best buying opportunities over the last five years appeared when the projected returns were at their highest level from October 2008 to April 2009, when investors could expect 10% a year from the U.S. market.

If average investors missed this opportunity, corporate insiders such as CEOs, CFOs and directors did not. As a whole they purchased their own company shares at more than double the normal rate from October 2008 to April 2009. Many of these purchases resulted in multi-bagger gains. This confirmed again the conclusions of earlier studies: The aggregated activities of insiders can serve as a good indicator for locating the market bottoms. Insiders as a whole are smart investors of their own companies. They tend to sell more when the market is high, and buy more when the market is low.

This is the current insider trend for S&P 500 companies:

The latest trends of insider buying are updated daily at GuruFocus' Insider Trend page. Data is updated hourly on this page. The insider trends of different sectors are also displayed in this page. The latest insider buying peak is at this page: September of 2011, when the market was at recent lows.

Conclusion: The stock market is not cheap as measured by long-term valuation ratios. It is positioned for about 1.7% to 4% of annual returns for the next decade. By watching the overall market valuations and the insider buying trends investors will have a better understanding of the risk and the opportunities. The best time to buy is when the market valuation is low, and insiders are enthusiastic about their own company's stocks.

Investment Strategies at Different Market Levels

The Shiller P/E and the ratio of total market cap over GDP can serve as good guidance for investors in deciding their investment strategies at different market valuations. Historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high-quality business and a strong balance sheet will provide better returns in this environment. When the market is cheap, beaten-down companies with strong balance sheets can provide outsized returns.

To summarize:

1. When the market is fair valued or overvalued, buy high-quality companies such as those in the Buffett-Munger Screener.

2. When the market is undervalued, buy low-risk beaten-down companies like those in the Ben Graham Net-Net Screener. Buy a basket of them and be diversified.

3. If market is way over valued, stay in cash. You may consider hedging or short.

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